Finance for Legal Funders 101: Speaking Finance


The litigation finance industry is one of the fastest growing areas of the financial field. And yet, there is a significant issue holding the industry back from reaching its full potential: the inability of legal funders to raise favorable capital.

This challenge, common within high-growth and emerging industries, causes a number of well-known problems, two of which many legal funders will relate to:

  1. Gaps in early-stage investments to get a venture off the ground
  2. Constrained operating capital resulting in cash-flow issues

This challenge is multilayered, and there is no silver bullet. However, legal funders can address one of the core causes today: the communication gap between legal funder executives and financiers. In my experience as a consultant to the industry, when litigation finance firms understand and pitch themselves using the proper financial language, not only does their cost of capital fall dramatically, but they also improve their business operations.

This article is the very first in a series on the language of finance. The goal is to show how legal funding companies can use established financial concepts to help bridge the communication gap between themselves and financiers so that the next time you are considering raising outside capital, you are equipped to pitch your business more effectively and raise capital on more favorable terms.

Why does the communication gap exist?

Let’s take a quick look at why this communication gap exists. To frame the problem simply, many litigation funders do not speak “finance.” First, through serving plaintiffs, attorneys, and law firms, the litigation finance industry is, in effect, an extension of the legal field. As an extension, it is predominantly peopled, not by financiers, but by attorneys, most of whom do not have finance backgrounds.

Second, the language of money is inherently complicated and esoteric, primarily because the underlying realities of any given financial concept are themselves complicated, as described in New Yorker article Money Talks: Learning the language of finance. This creates a high barrier of entry for the uninitiated when engaging with financiers.

These two factors become a problem for successful legal funders who eventually find themselves interacting with the financial sector without a shared vocabulary. Litigation finance firms often find that they can’t secure as much capital as they’d like. Even when they are able to obtain the capital they need to fuel their growth, and the cost is significantly higher than it should be given the risk profile of the asset.
This chasm, ultimately limiting litigation funding’s growth, makes it hard for new companies to start, as well as keeps margins slim for established funders.

Why “Speak Finance”? Affordable and Accessible Capital & An Improved Business Today

The benefits of legal funders adopting a few core concepts of finance are nothing short of business changing, and cumulatively they can alter the path of the industry as a whole.

The first order effect experienced by legal funders who understand and present themselves through a financial lense is, of course, cheaper capital. The second order effect, which is often overlooked, is that the funds also tend to have an easier time raising subsequent funds, especially from institutional investors. Nearly every litigation finance firms out there has one of two problems – either 1) they are struggling to get enough capital, or 2) they have plenty of capital and need to be careful about deploying it. The funds that fall into that latter category usually have the benefit of a strong team with a deep finance background.

For comparison, we need to look no further than my other favorite alternative investment class, the reinsurance space.

Reinsurance is similar to litigation finance in terms of market size, the esoteric nature of the field, and the speed of growth. Yet in reinsurance, the cost of capital is roughly 6% at present, compared to litigation finance where it is often 20% or more. Some would say that reinsurance as a whole should have a lower cost of capital because it’s inherently less risky, but the statistics don’t bear that out. Instead, the cost of capital difference appears to be driven by differences in market structure and in the way the litigation finance industry presents itself versus the reinsurance industry.

The benefits of speaking finance go beyond just a lower cost of capital and ease of fundraising. Finance exists as a field for a reason, and it is because it helps business managers make sense of the outlook for the business and take action to control the future. Just as good accounting is critical for knowing where a business has been, good finance is critical to controlling where a business is going. Smart litigation finance firms recognize this and use appropriate financial metrics to help guide the investments they are targeting.

Summary

Litigation finance is doing a lot of things right.  The field is growing rapidly because it serves a fundamental business need. That’s important to always keep in mind. Yet growth will continue to be constrained if the legal side of litigation finance fails to speak the same language as the broader swath of institutional investors around the world. Lower costs of capital from investors would let litigation finance firms lower their own rates of lending to plaintiffs and still earn a healthy return.

The first step to lowering those costs of capital is to begin thinking about how concepts like duration and convexity can be applied to the litigation finance world. That will be the subject of the next article in our series.

If you want to connect on this topic, don’t hesitate to shoot me an email: m.mcdonald@morninginvestmentsct.com


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About Michael McDonald

Michael McDonald is a PhD in finance, former Wall Street trader, and hedge fund quant. Currently, he is a university professor of finance and partner at the investment consulting firm Morning Investments. His firm provides services for hedge funds, asset managers, and litigation finance firms. He is also a periodic columnist for AboveTheLaw.com and the Litigation Finance Journal. He can be reached at: m.mcdonald@morninginvestmentsct.com

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